Netflix CEO Unbowed

Ignoring Customers' Anger, Company Says Separating DVD Business Is Essential

Netflix's decision to split itself into DVD and streaming services has hurt its reputation enough to warrant an apology from CEO Reed Hastings.

By

Ethan Smith

September 20, 2011

If the CEO of Netflix Inc. were in a movie, the townspeople would be chasing him with torches and pitchforks.

The customer reaction was swift and angry against Reed Hastings's late Sunday announcement that the company was separating its DVD-by-mail business and its "Watch Instantly" Internet movie-streaming businesses.

Still, Mr. Hastings, a co-founder of the company, indicated that he's willing to take the short-term heat—and risk losing yet more customers—to usher Netflix into its new digital identity, focused not on snail mail but movies over the Web.

Calling It Splits

Several companies have announced plans to split themselves apart in recent months.

In his overnight email to the company's 23 million domestic subscribers, Mr. Hastings said the DVD business will be renamed Qwikster, hived off into a separate subsidiary that will have its own billing system, website and list of movies.

By late afternoon on Monday, more than 16,000 users had left comments on the Netflix blog— and the overwhelming majority were livid.

"You are making things significantly worse for us," one customer wrote, in a screed that echoed many of the others. "Now not only will we have to pay a LOT more for your services, but we will also have to access two separate websites."

The transition from physical to digital hasn't been easy for any media business. The pain often has been exacerbated by attempts to hang onto their old businesses without focusing on new ones. Mr. Hastings is betting that rankling subscribers is preferable to falling behind those changes.

Two months ago, Netflix said it would price its offerings separately, starting at $8 with no discount for combining the two, an apparent move to accelerate the migration to Web viewing from mailed movies. Just last week, Netflix said price change was costing it more subscribers than it expected. On Sunday, the company conceded that was the first step in creating Qwikster.

Many angry customers, threatening to cancel their Netflix subscriptions, griped that the selection of titles for streaming is small compared to the DVDs. Netflix offers about 100,000 DVD titles and has about 20,000 titles in its streaming library, estimates Wedbush Securities analyst Michael Pachter. The company doesn't disclose the size of its library.

Many users also noted that movies and videos are increasingly available elsewhere on the Web, giving them options.

Underscoring that notion, Dish Network Corp. is expected to soon unveil some kind of streaming service. On Monday, Dish said its recently acquired Blockbuster video-rental chain would make "a stream come true" announcement on Friday. Dish declined to comment.

According to person familiar with his thinking, Mr. Hastings is willing to endure the current drubbing because the long-term dynamics indicate that people will be less and less reliant on the DVD side of the business. By separating the two now, Netflix appears to be preparing for the day when the DVD business dwindles or even disappears.

Netflix expects its DVD business to remain viable for only about 15 more years, the person said. Separating the two businesses could keep the DVD operation alive longer by letting its managers concentrate on their own needs, without the distractions of running the online business.

Netflix shares dropped 7.3%, or $11.39, in a broad market sell-off on Monday, to $143.80, on the Nasdaq Stock Market

Wedbush's Mr. Pachter called Netflix's separation plan "premature," citing the changing economics of the DVD and streaming businesses. He estimates that for now, streaming-only customers are more profitable to Netflix than its DVD customers. But he believes that state of affairs won't last as studios charge Netflix more for the digital licensing deals it relies on.

"On the DVD side the studios have zero ability to raise price," Mr. Pachter says. "On the streaming side, the studios have 100% leverage."

Subscribers to Netflix's DVD-by-mail business, created in 1997, have been leveling off, according to recent company data, while the number of subscribers to its movie-streaming business have grown rapidly since its introduction in 2007.

After assessing the fallout from the price increase, Netflix said it expects to end this month with 2.2 million DVD-only subscribers, down from the previous forecast of 3 million, and 9.8 million streaming-only customers, down from an earlier forecast of 10 million. The company's forecast for combination subscriptions held steady at 12 million. Its current 23 million total subscribers represent a 37% increase from the year-ago level of nearly 16.8 million.

Netflix has run almost no ads promoting its DVD business in the past six to eight months. At the same time, the company has been aggressively expanding the streaming business, moving into Latin America and exploring other international markets.

Though the move could make it more costly for Netflix to license content for its streaming service, it is unlikely to have much effect on the costs of the DVDs it buys from movie studios and television companies. Studios often negotiate DVD and digital deals separately, with Netflix and with other companies, according to people in the movie and technology businesses. Walt Disney Co.'s movie studio is in the process of separating its DVD and digital-distribution operations. DVD sales are being transferred to the consumer-products group that sells toys and clothes to chains like Wal-Mart Stores Inc., while responsibility for striking digital deals will remain with the studio.

Among the factors making the DVD and streaming businesses so different: Streamed versions of movies remain subject to the complex "windowing" deals studios strike with television broadcasters and others. Generally when movies are being shown on premium-cable channels like HBO and Showtime, for instance, they cannot also be available on a service like Netflix. By contrast, Netflix owns outright the DVDs it rents, and can do with them as it likes.

To preserve discounts on bulk purchases of DVDs, Netflix has been willing to make concessions such as waiting 28 days after some movies come out on DVD before offering them to mail-order subscribers. Studio executives view that as a way of protecting DVD sales. Last year domestic DVD and Blu-ray sales generated $5.6 billion in revenue for the studios, according to an estimate from IHS. Physical movie rentals, meanwhile, generated $1.6 billion.

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